shadow banking

September 17, 2013

The dominant narratives now circulating five years after the height of the financial crisis typically conclude that the financial system is still very risky, or even riskier, since the September 2008 fall of Lehman Brothers.

While it is true that banks are still too big, too leveraged, and too short-term-funded, it is important to emphasize that the financial system is much safer because its most dangerous aspects is now a relic.

Specifically, mortgage-backed shadow banks no longer exist. The run up to the financial crisis saw the explosion of various types of securitization vehicles that were collateralized by private-label residential mortgage-related securities. These vehicles took the form of second-level securtizations financed by long- and medium-term liabilities (cash and synthetic collateralized debt obligations) and vehicles that largely issued commercial paper (asset-backed commercial paper conduits and structured investment vehicles).

As plenty of academic research has documented, bank-like "runs" on the short-term funding vehicles precipitated the financial crisis and made it especially severe in the fall of 2008. These runs caused banks to lose financing and suffer direct losses as the vehicles' losses became their own.

But mortgage-backed securitizations funded by short-term liabilities are a thing of the past. According to SIFMA statistics, outstanding U.S. asset-backed commercial paper plummeted from a peak of $1.1 trillion in 2006 to $262 billion by August 2013--and whatever remains is not collateralized by residential mortgage-related securities.

In addition, the amount of liabilities shadow banks issue are likely to continue to decrease. As noted in a June 2013 Standard and Poor's research report, the total liabilities of all shadow banks may even "fall below total deposits in the banking sector sometime in 2014," which would be a first since 1993. Lack of investor appetite and changes to capital regulation and off-balance-sheet accounting standards are the likely causes.

The following graph from the S&P report illustrates the trend:

Although new bank regulations are pushing credit activity into shadow banks, the fact that the most dangerous types of them are no longer financing the core of the financial system is--five years after the crisis--something worth celebrating.